Answer: Bebchuk and Fried (the authors) take the following dual approach to the analysis of executive compensation contracts:
1. That, as designed by the board and shareholders, contracts help alleviate agency problems between managers and shareholders (the “optimal contracting” approach).
2. That they are a part of the agency problem itself (the “managerial power” approach).
While the traditional compensation literature takes the optimal contracting view, it is difficult to see, at least with hindsight, why a competing approach did not exist for some time. After all, no contracts are complete or without side effects. It is somewhat more confounding, when one is provided an overview of the limitations of the optimal contracting approach. Specifically, the authors provide the following challenges to the approach:
A. Faulty logic: If managers need contracts to optimize their behavior as agents, why wouldn’t directors? The optimal contracting approach is based on the simplistic assumption that directors are implicitly good representatives of shareholders.
B. Director incentives: Directors who wish to be elected or re-elected are not likely to be adequately confrontational with the CEO because the CEO ultimately has influence over the director selection process. The hope that directors’ share ownership would lead them to overcome this hurdle is not borne out by the data because directors own too little of the companies on whose boards they serve.
C. Market forces: Under the optimal contracting approach market forces are assumed to keep the players honest and the contracts clean. However, there is substantial evidence of firms insulating themselves from such forces, at least partially.
The immediate counter challenge that presents itself to the authors is this – if the optimal contracting view does not work why haven’t contracts become more skewed? The authors set the table by arguing that their approach is not binary, i.e., no single approach dominates. Further, to the extent the optimal contracting approach may not work, there are mitigating forces such as “outrage” costs that keep from things getting too out of hand. Public outrage is likely to keep management and boards in check. But not only that, fear of such outrage may also explain why contracts are set up in certain ways. For example, taking more compensation via options quelled such outrage for a while because options were mostly viewed as being properly performance-linked. Similarly, when taking excess compensation the use of less visible ways to do it is explained by such outrage. Finally, in periods of boom such outrage arises less frequently and that helps explain why compensation contracts have become excessive.
The authors then proceed to lay out the formal components of the managerial power approach. These include the following:
A. Power-pay relationship: Under the optimal contracting approach, institutional arrangements such as the power of the board (including its independence, the presence of a large shareholder etc.), or the concentration of institutional shareholders or the presence of antitakeover provisions in the company’s charter should not influence the design of compensation contracts. However, extensive evidence suggests they do. Why?
B. Compensation consultant: The use of consultants to validate excessive compensation packages is similarly incompatible with the optimal contracting approach but fits well with the managerial power approach.
C. Stealth compensation: The use of large hidden components via low-interest and forgiven executive loans, excessive retirement and other deferred benefits, are also more compatible with a…